The financial accounting term unearned revenue refers to revenues received in advance of rendering a service or providing goods to customers. Unearned revenues are recorded as a liability since it represents an obligation of the company derived from a transaction that occurred in the past.
The Revenue Recognition Principle, along with the Matching Principle, dictate revenue is recognized when two criteria are met:
- Realized / Realizable: products, merchandise or services are exchanged for cash or claims to cash (realized) or when an asset received is readily converted into cash (realizable).
- Earned: occurs when the business has substantially accomplished all that it must do to be entitled to the revenue. For example, a product is delivered or a service is rendered.
Unearned revenue is an accounting adjustment that occurs when revenue is received but not yet earned. This can happen when a customer prepays for a product or service. Examples include annual service contracts, rents, and magazine subscriptions. Customers pay for these goods or services upfront, with delivery occurring in the future.
As part of the accounting cycle, unearned revenue is an adjustment that occurs after a trial balance, and prior to the production of the company's financial statements.
On July 1, Company A purchases a maintenance agreement on their call center's backup generator with Company B. The agreement is for a term of 24 months, and the upfront cost is $12,000. Company A records this transaction as a prepaid expense, while Company B accounts for this agreement as unearned revenue.
The adjustment made by Company B is as follows: